International Financial Markets

Financial markets are often designated as money markets and capital markets.

*Money Markets are markets for short term financial assets (Short-term instruments) e.g., T-Bills, CD's, Bankers Acceptance(BAs), Commercial Papers(CP), Repurchase Agreements (Repos)...
*Capital Markets are markets for long term financial assets like Bonds, Stocks, Mortgages, etc. We will emphasize two major components of International Financial Markets: i. The Foreign Exchange Market ii. Eurocurrency, Eurocredit, & Eurobond Markets 1

Money Market (MM):

In the MM, investors can buy S-T debts of governments, banks, financial institutions, and corporations. Maturity varies from 1 day to 1 year Highly marketable Quickly convertible to cash (very liquid) Un-collateralized debt of issuers with high credit rating Quoted by using annualized discount yields (negotiable CDs are exceptions)

Negotiable CDs: Denominations of over $100,000 Depositor able to negotiate interest with bank Maturities range from 14 days to 1 year.
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T-Bills: U.S. Treasury Department sells T-Bills. The Federal Reserve Bank (FED) acts as fiscal agent and conducts the yield auction. Commercial Paper (CP): Unsecured IOUs of corporations with good credit. Maturities range from a few days to 270 days. Usually issued in denominations of $100,000 or more. About 1000 corporations issue CP in the U.S. Bankers Acceptances (BA): Denominations of over $100,000. Sold at discounts.

Repurchase Agreement (REPO): In a REPO, buyer and seller of a security agree that seller will repurchase security after a certain length of time or after conditions are met. Seller repurchases security at a higher price. Euronotes:

Short-term promissory notes issued by a corporation and sold to private or institutional investors Typical maturity is 3 to 6 months Sold originally at a discount from face value. Trade in secondary markets Underwritten by international investment/commercial banks
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Euro Medium Term Notes Similar to domestic medium term notes, with maturities of 9 month to 10 years. Fill the gap between S-T and L-T euro debt instruments
Eurocommercial Paper Unsecured short-term notes issued by corporations and banks in the Eurocurrency Markets Typical maturities from 1 to 6 months Placed directly with investors through dealers.
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Eurocredit (bank loans denominated in eurocurrencies and extended by

banks in countries other than in whose currency the loan is denominated)

Loans of one year or longer extended by Eurobanks to MNCs or governmental agencies.

Money Market Mutual Funds:

Bring market for T-Bills, Commercial Papers, and others to the small investor.

The Foreign Exchange Market: An Outline Organization: Functions, Participants, Size Spot market: Quotations Bid/Ask Spreads Cross rates Location arbitrage Triangular Arbitrage Transaction costs. Forward Market: Quotations Maturities Bid-Ask spreads Premium/Discount Use of the Fwd. Mkt. by MNCs

The Forward Swap: The Swap Price

Derivative Securities: The Forward Market The Futures Market The Options Market The Swaps Market The Eurocurrency Markets: Definitions Eurodollars / Euro-currencies Evolution of the Market Deposit Creation The Eurocredit Market: The Eurobond Market: .
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 The

Foreign Exchange Market is the world's largest financial market.

The Bank for International Settlements estimates daily trading volume of about $3.2 trillion. (WSJ 09/26/07)

The

Foreign Exchange Market is an over-thecounter market.

That means there is no physical location where traders get together to exchange currencies. Rather they are located in the offices of major commercial banks around the world and trading has historically been done by telephone, telex, or the SWIFT system.
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 The

Society for Worldwide Interbank Financial Telecommunications(SWIFT) is an international bank communications network, that electronically links brokers and traders. network connects over 7000 banks and brokerdealers in over 192 countries.

The

SWIFT

transports financial messages in a highly secure way, but does not hold accounts for its members and does not perform any form of clearing or settlement. SWIFT does not facilitate funds transfer.
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An international payment system should provide:

Security of value - instrument adequately transfers appropriate value Security of medium - instrument hard to fake. Storage security instrument cant be easily stolen or its value appropriated. Portability instrument can be used to transport sufficient value. Negotiability others will accept the instrument. Convenience low cost and speed of instrument transfer. Legal recognition and formalism rules of the system 11 adequately regulated by state.

Global Settlement System

CLS

Bank International, a New York-based settlement network, is supported by over 70 of the worlds largest banking and financial institutions. offers a unique real-time processing that enables simultaneous FX settlement across the globe thereby eliminating settlement risks caused by delays arising from time-zone differences.

CLS

Internet resource: www.cls-group.com

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Trading takes place somewhere in the world 24 hours a day and frequently between individuals or institutions located in different countries. Most trading activities take place in a few currencies like the US Dollar, the Euro, the British Pound, the Japanese Yen, the Canadian Dollar, and the Swiss Franc The foreign exchange market is not confined to any one country but dispersed throughout the worlds leading financial centers: London, New York, Tokyo, Paris, Zurich, Amsterdam, Hong Kong, Frankfurt, Toronto, Milan, Singapore, Berlin, Vienna, Chicago...

Foreign

Exchange traders not only buy and sell currencies but, they create prices.
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 Market

Makers are those traders in the major moneycenter banks around the world who are always ready to buy or sell by quoting the bid/ask prices. They create the market by creating bid/ask prices and dealing at those prices. difference between the two prices is called the spread." in the FX market include importers, exporters, portfolio managers, central banks, brokers, commercial banks, arbitragers, speculators, tourists, governments, etc.
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The

Participants

The Foreign exchange market can be subdivided into: The Retail Market: permits the firms and individuals to obtain foreign exchange for business or personal use.

The Interbank Market: major participants are foreign exchange traders employed by large banks. Also large Multinational Corporations often maintain trading departments that operate directly in this market. Traders in the interbank market are called dealers." They make the market. Brokers: bring buyers and sellers together for a small commission thereby helping to preserve the anonymity. Arbitragers: seek to profit from price differences in different foreign exchange markets.

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Speculators: buy and sell in the hope that a price change will result in a profit. Governments: Central Banks, Treasury Departments and other Government Agencies sometimes participate in the market in order to influence the exchange rate of a particular currency.

For Example: FED buys dollars in foreign exchange market to increase the value of the dollars. FED sells dollars in foreign exchange markets to reduce the value of dollars. Coordinated efforts among central banks are often used. For example, the US FED bought the Mexican peso to help prop up its value in early 1995. 16

Other Participants (mainly in the forward markets)

Traders: Use forward contracts to eliminate or cover the risk of loss on export or import orders that are denominated in foreign currencies. Hedgers: Hedgers, mostly Multinational corporations, enter into forward contracts to protect domestic currency value of foreign currency denominated asset and liabilities on their balance sheets.

The increasing importance attached to exchange rates results from the globalization or internationalization of modern business, the continuing growth in world trade, the trend towards economic integration and the rapid pace of change in the technology of money transfer.
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The Clearing System: Modern technology plays a central role in the international transfer of funds or settling foreign exchange transactions. In the U.S., electronic funds transfer takes place through the Clearing House Interbank Payment System (CHIPS). This is a computerized network developed by the New York Clearing House Association for transfer of international dollar payments. It links about 150 depository institutions that have offices or affiliates in New York City. The New York Fed has established a settlement account for member banks in which the account of a paying bank is charged and the receiving banks account is credited. 18

Electronic Trading:
In

1992, Reuters introduced a new service that added automatic execution to the screen quotations used in telephone trading thereby creating a genuine screen-based market. Other vendors like Telerate and Quotron, followed.

Electronic

trading systems offer automatic matching in which traders enter buy and sell orders directly into their terminals anonymously.
prices are visible to all market participants and any trader anywhere in the world can execute a trade by hitting two buttons! 19

These

Several questions are commonly asked in relation to the foreign exchange rates. These include: 01) 02) 03) 04) 05) 06) 07) Why do exchange rates change Why is it so difficult to forecast exchange rates How can the Foreign exchange rates be forecasted Why governments intervene in the exchange market How to effectively hedge foreign exchange risks How to speculate in the foreign exchange markets How to evaluate the comments on exchange rates found in the financial press 08) Government policy issues with respect to exchange rates (e.g., fixed and floating regimes) 09) What we know and what we do not know yet about exchange rate dynamics. 20 10) Why are some calling for a return to the gold standard

Functions of the Foreign Exchange Market:

Transfer of Purchasing Power: International trade and capital transaction usually involve parties with different functional currencies. Trade and capital transactions can be invoiced in any convenient currency. Therefore, one or more of the parties must transfer purchasing power to or from own national currency. The Foreign exchange market facilitates this transfer of purchasing power.

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Provisions of credit:

Movement of goods and services between countries takes time. This gives rise to financing of inventory in transit and sales inventory. foreign exchange market provides a means of transfer of credit. Specialized instruments like Bankers' acceptances and letters of credit, are made possible through the foreign exchange market.

The

Minimizing Foreign Exchange Risk: The foreign exchange market provides "risk transfer" facilities to third parties via forward, futures, options, and swaps markets.

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Formal Definition:

The Foreign exchange rate is the domestic currency units per unit of a foreign currency. Example: Let the U.S. be "domestic" 1. If you need $1.95 to purchase 1 unit of the British Pound Sterling, then $/ = 1.95 (d/f) Dollars per pound is a direct quote for the pound in the U.S. It means the home currency, in this case the $, (or domestic currency) needed to acquire one unit of a foreign currency, in this case the pound.
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Alternatively:
The

foreign exchange rate can be defined as units of a foreign currency per unit of domestic currency. This is an indirect quote. purchase one unit of the U.S. Dollar, then:
/$ = 125 (f/d).

2. If 125 units of the Japanese Yen are needed to

This is an indirect quotation for the Yen in the US.

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Since the direct and the indirect quotations are alternative means of stating exchange rates, the two methods are related. One is the inverse of the other. Thus $ = 1 /$

or,

= 1 $ $/ Most interbank quotes are quoted around the world are stated in "European" terms which means the foreign currency price of one dollar, e.g., SF/$ = 1.2378, /$ = 132, etc. The alternate way, dollar price of one unit of foreign currency, is called "American" Terms e.g. $/ = 1.7535. 25

 Spot

Rates:

A spot transaction is the purchase of foreign exchange for immediate delivery (usually, delivery within the following 2 business days).

Forward

Rates:

A forward exchange rate or forward rate, is the price agreed on today for purchase or sale of foreign currency for future delivery (transfer/settlement) and payment. The rate is agreed on at the time the contract is made, but normally payment and delivery are not required until maturity. Forward maturities normally are 30, 60, 90, 180, 360 days in to the future. Odd maturities may be negotiated for one to two weeks or even up to 5 years.
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 Cross

Rates:

Frequently,

the need arises to obtain the relationship (price) between two currencies from their relationship with (quotation in) a third currency. given two currencies A & B. If $/A and $/B are given, then the value of A in terms of B (or B per unit of A) is given by:
*

Formally,

$/A = $ $/B A This is the cross rate.

B = B $ A
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Examples: Given $/ and $/SF, then $/ = $ * SF = SF $/SF $

Given:

$/ = 1.4155 and SF/ = 3.1318, then SF = SF/ = 3.1318 = 2.2125 $ $/ 1.4155

$/ = 1.8632; $/ = .008013, then = $/ $/ = 1.8632 = 232.52 .008013
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Given:

The Bid-Ask Spread:

Bid Price: price at which a dealer will buy a currency. Ask price: price at which the dealer will sell a currency (offer price). Dealers do not normally charge a commission on their currency transactions but profit from the bid/ask spread.

Computing the bid/ask spread in percentage terms:

Bid/Ask spread Ask Rate - Bid Rate * 100 Ask Rate 1 This expresses the spread in terms of the "discount" obtained by the dealer. =

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Alternatively, Bid/Ask spread = Ask Rate - Bid Rate * 100 Bid Rate 1 This expresses the spread in terms of the markup established by the dealer. Outright and Points Quotations:
In

outright quotations the full price is given to all its decimal points. In points quotation abbreviations are used.
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 For example, the may be quoted at $1.9819-36. This means a bid price of 1.9819 and an ask price of 1.9836. In practice, this quotation may simply be given as 19-36 as the dealers are sufficiently up to date to know the preceding numbers.

The last digit in a quotation represents point(s), and convention dictates the numbers of decimal points in each quotation. For example:
$/ = 1.9825 (4 digits) $/Y = .008799 (6 digits)
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Forward Quotes With Bid/Ask Spreads:

Interbank quotations are expressed as a bid (buy) and an offer (sell or ask). Bid and Ask quotations may appear complicated because the bid for one currency is also the ask of another currency. In outright quotations the full price is given to all its decimal points. In points quotations abbreviations are used. When quotations in European terms (indirect) are rendered in American terms (direct) the bid and the ask reverse. The reciprocal of the bid becomes the ask and the reciprocal of the ask becomes the bid

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In the Interbank market, dealers usually quote the forward rate as a discount from or a premium on, the spot rate. This forward differential is called the "Swap Rate". Example: Given that: : spot $/ = 1.7860 : spot $/ = .007949 90-day Fwd = 1.7580 90-day fwd = .007929 The "Swap Rate" (forward differential) for the was quoted as a 280-point discount (from the spot). The "Swap Rate" for the 90-day forward Yen was quoted as a 20-point discount from the spot.
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A "Swap Rate" can be converted into an outright rate by adding the premium (in points) to or subtracting the discount (in points) from the spot rate. When the forward bid (in points) is smaller than the Ask rate (in points) the forward rate is at a premium and the points should be added to the spot price to compute the outright quote. Conversely, if the bid (in points) exceeds the ask (in points), the forward rate is at a discount and the points must be subtracted from the spot price to obtain the outright quotes. Note that the buying rate, spot or the forward, is always less than the selling rate and forward bid/ask spread always exceeds spot bid/ask spread. 34

Example: The following quotes are given for the respective maturities for the and the SF.

Spot 1 Month : $2.0015-30 19-17 SF: $0.6963-68 4-6

3 Months 26-22 9-14

6 Months 42-35 25-38

Compute the outright quotes.

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 ( $/) Maturity Spot 1 Month 3 Months 6 Months Bid 2. 0015 1. 9996 1. 9989 1. 9973 Ask 2. 0030 2. 0013 2. 0008 1. 9995 Spr ead% 0. 075 0. 085 0. 095 0. 110 Bid 0. 6963 0. 6967 0. 6972 0. 6988

SF ($/SF) Ask 0. 6968 0. 6974 0. 6982 0. 7006 Spr ead% 0. 072 0. 100 0. 143 0. 257

This example shows that the SF is selling at a premium while the is at a discount against the $. Note the slightly wider spread between outright bid and Ask on the Swiss Franc compared to the spread on the pound. The difference is due to the broader market in pounds. Also the widening of spreads over time for both currencies is caused by the greater uncertainty surrounding future exchange rates. 36

The Bid/Ask Spreads in Cross Rates:

Consider the following quotes: $/ = $ 1.7109-36 $/SF = $ 0.6250-67 Find the direct quote for the in terms of the SF (with B/A spread). i.e. find SF/ in b/a quotes. The bid and ask quotes for SF/ are:

BID:

SF

= SF $

$ =

1 * 1.7109 = 2.7300 .6267 1

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ASK:

SF = SF * $ = 1 * 1.7136 = 2.7418 $ .6250 1 Hence the cross rates with B/A spreads are: SF/ = 2.7300 - 2.7418 or = 2.7300 418

Sometimes a forward transaction is called an "outright forward" to emphasize that no spot transaction is involved and to distinguish it from a "swap transaction"

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A "swap transaction" involves the sale of a foreign currency with a simultaneous agreement to repurchase at some later date in the future; OR The purchase of the foreign currency with an agreement to resell at sometime in the future. Generally a forward swap is an arrangement in which two parties agree to exchange specific amounts of currencies on one date and to reverse the exchange, usually at a different exchange rate, on a later date. The arrangement can be a spot-forward or forward-forward swap. These forward swaps differ from currency swaps in that there are no exchanges of interest payments and are usually for shorter time periods. Spot - fwd swap: Spot now with fwd later; 39 Fwd - fwd swap: fwd at t with fwd at t+30.

Example:
City Bank buys SF5 million from the Swiss Bank for $2 million (spot) and simultaneously agrees to sell the SF back in 6 months for $ 2.1 million.
The

difference between the sale price and the repurchase price is called the swap rate swap is a way to borrow one currency for a limited time while giving up the use of another currency for the same time, i.e., a short-term borrowing of one currency combined with a shortterm loan of an equivalent amount of another currency. 40

This

Note:
According to the Bank for International Settlements (BIS), in 2001, spot transactions account for 33% of the market, forward transactions 11%, and swap transactions, (involve a package of spot and forward contracts), 56% of the market.

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Exercises:
1.

A trader quotes the SF against the $ at a Bid/Ask (buy/sell) price of: SF/$ = 2.3697 - 2.3725. The principle of buy low and sell high applies. The smaller number 2.3697 is the bid price and the larger number 2.3725 is the ask price. Obtain the bid/ask prices for $/SF.

2.

If a bank quotes bid/ask prices SF/ = 4.085-4.090. What should be the bid/ask prices for /SF?
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3. A bank is currently quoting the following rates: i) SF/$ = 2.3697-2.3725 $/ = 1.5525-1.5535 What SF/ cross rates bid/ask would the bank quote? ii) SF/$ = 2.5110-2.5140 /$ = 245-246 Find /SF Bid/Ask rates. iii) DK/$ = 5.5279-5.5289 SK/$ = 6.8681-6.8691 Obtain SK/DK bid/ask rates.
(DK = Denmark krone)

(SK = Sweden krona)

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Premium or Discount on Forward Rate:

If the forward rate exceeds the existing spot rate (direct quotes) it contains a premium. If the forward rate is less than the spot rate, that forward rate contains a discount. To compute the Premium (Discount) Let: F = Forward rate e.g., $/ = d/f S = spot rate n = time to maturity then: For a direct quote of the (e.g. quoted as $/ = 1.5235): F-S * 360 gives premium (discount) on the . S n
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For an indirect quote, (e.g. quoted as /$ = .6564)

S-F * 360 gives premium (discount) on the pound. F n
A

premium means that the direct price in the forward market is higher than the direct price in the spot market. A discount is the reverse.

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Examples:
Spot ($/SF) 30-day Forward 90-day Forward 180-day Forward .4520 .4541 .4585 .4654

a. Obtain the p (d) on the Swiss franc in each case. b. Compute the p (d) on the dollar in each case.

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Using The Forward Contract: an Example

A U.S. importer of German BMW receives a bill of 2m for the 700 series. The Bill is payable in 90 days. Spot $/ = 1. 3467. The 90-day forward $/ = 1.3495. The Forward contract is a means of locking in the price at which euros will be acquired in 90 days. Discuss.

Percentage

Change in Exchange Rates:

The percentage change in exchange rates can be obtained as follows: % change = Ending Rate - Beginning Rate * 100 Beginning Rate 1
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Example: Given that: at t = 0 : $/ = 1.7895 t = 1 : $/ = 1.9795 % = 1.9795 - 1.7895 1.7895 |----------------------------| 0 1

* 100 1

= 10.62

The pound has appreciated in value against the dollar by 10.62% during the given period.
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Some Common Terms:

Depreciation -- Devaluation -- Weakening Appreciation -- Revaluation -- Strengthening Soft Currency -- Expected to decrease in value Hard Currency -- Expected to maintain its value to increase in value.

Dollar is Mixed -- The $ did not move in one

direction against the major currencies - up with some, down with some.

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Arbitrage in Foreign Exchange Market:

Arbitrage is one of the most powerful forces at work in a market economy. It is the simultaneous purchase and sale of the same (or essentially similar) good or security in two different markets for advantageously different prices - provided that the price spread more than offsets transaction costs. Arbitrage plays a critical role in the analyses of security markets because its effect is to bring prices to their fundamental values and keep markets efficient. The effect of arbitrage is to reduce/eliminate price differentials on identical products by arbitragers buying low and selling high to realize riskless profit.
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Locational Arbitrage:

The prices charged by different banks for foreign exchange cannot vary significantly. Prices are kept more or less in line with each other through a process called Locational Arbitrage If the price of a foreign exchange varies from one bank to another, an arbitrager will be able to "buy low" and "sell high." Such an activity should lead to an increase in the rate at the low-priced bank and decrease in the rate at the highpriced bank.
Arbitrage activity will continue as long as the difference in prices is large enough to generate a profit. 51

EXAMPLE: Bank A Bank B Bid price for X $ .50 $ .52 Ask price for X $ .51 $ .53 In this example profitable arbitrage opportunity exists. Given that the arbitrager has $1m.

Buy X from bank A at .51 and simultaneously sell them to Bank B at .52. If $ 1,000,000 are available then, $1,000,000 will buy X = 1,000,000/.51 = 1,960,784. Sell to Bank B for 1,960,784 * $.52 = $ 1,019,608 for a profit of $19,608.
The high demand for X in Bank A leads to an increase in price and increased supply of X in Bank B leads to a decrease in price.

Such a situation usually disappears before most firms even become aware of it. 52

As an example of how arbitrage works, consider a large bank in London. The Chief of the FOREX department, Dollar($) section, observes over the telex that the $ prices of Pound ($/) spurts up in New York. Here is a chance to make some money! To exploit the situation, the arbitrager does two things: First he/she contacts a broker or a correspondent bank in New York and sells, say 1m (sells high). At almost the same time he/she buys the same amount of s in London. If the arbitrager does not buy and sell at almost the same instant the spread appears, there is a risk of missing the opportunity. 53

 The

sale of pounds in New York where the price is high and the repurchase in London, where the price is low, contributes to eliminating the price deferential.

As

other market participants take similar actions, the price differences appears.

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Triangular Arbitrage:
Example 1: Consider the following quotes in New York, Frankfurt, and London. (Assume no transaction costs) FRANKFURT ($/ = 1.2471) LONDON (/ = 1.4544) NEW YORK ($/ = 1.8590)

Is Triangular Arbitrage feasible? Show why/why not.

Describe

a strategy to profit from triangular arbitrage. What percentage profit is possible?

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Solution:
FRANKFURT $/ = 1.2471 NEW YORK $/ = 1.8590

London / = 1.4544

On the Bases of New York and Frankfurt quotes: = * $ = 1 . 1.859 = 1.4907 $ 1.2471 The is worth more in London (fewer required to buy in London) Hence acquire elsewhere and sell it in London. 56

e.g. $ Given 1m: 1000000 * 1 * 1.8590 * 1 = 1,024,930 1.4544 1.2471 Profit = 24,930 2.5 .
Arbitrage

activity causes to appreciate against in London, the $ to appreciate against the in New York and the against the $ in Frankfort.

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Example 2: Assume no transaction cost. Suppose 1 = $1.8095 in NY, $1 = C$1.3215 in Toronto and C$1 = 0.4342 in London. Show whether or not triangular arbitrage opportunities exist How could a trader profit from triangular arbitrage? Compute the percentage profit possible. Solution:
NY $/=1.8095 Toronto C$/$=1.3215

London /C$= 0.4342

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Given New York and Toronto quotes:

= . $ =
C$ $ C$

1
1.3215

= 0.4182

1.8095

The C$ is worth more in London than implied by cross rates from NY and Toronto.
It will be profitable to acquire C$ and sell it for in London.

C$ $ C$
Given C$ 1000 1000* 0.4342 * 1.8095 * 1.3215 = C$1,038.28 Profit = 3.828%
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Example 3: Assume zero transaction costs: A: /U$ = 106.50, B: C$/U$ = 1.3215 , C: /C$ = 82.905 Determine if triangular arbitrage is feasible. State what you would do to profit from arbitrage. Obtain the percentage profit possible. Solution:
A /U$ = 106.50 B C$/U$ = 1.3215

C /C$ = 82.905
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By cross rates from A & B, = . U$ = 106.50 . 1 = 80.590 C$ U$ C$ 1.3215 The C$ is more valuable at C: Borrow C$ and sell it for at C, Sell for U$ at A and the U$ for C$ at B. e.g. C$ U$ C$ Given 1C$: 1 * 82.905 * 1 * 1.3215 = C$1.02772 106.50 Profit 2.8%
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Transaction Costs:
Assume transaction cost is .6% (.25%, .35%). With a .60% Trans. cost, each stage the arbitrager receives 99.4% of what he previously received. There are three transactions in this example and these can be incorporated as follows: --- insert equation here ---

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Derivative Securities Markets: An Overview

These are forwards, futures, options, and swaps.

Forward Contracts are "private" contracts offered by banks that provide for the purchase or sale of units of a currency at a specified exchange rate for future delivery and settlement.

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 Currency

Futures Contract: Permits the exchange/trading (purchase or sale) of a specified number of contracts of a currency at specified exchange rate for future delivery. Prices are determined by an auction process on the floor of an organized futures exchange. Unlike the forward contracts, the futures contract entails daily settlements (marking to the market) and the posting of a margin. Currency futures contracts contain standard units of the underlying currencies. 64

 Currency

Options Contract: Is an exchange traded contract which grants the buyer (holder or owner) the right, but not the obligation, to purchase or sell a specified number of contracts of the underlying currency at a prescribed price (the strike price or exercise price) within a given period of time. The buyer pays a premium to acquire this right. Contract sizes are standardized.

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Swap contract is a contractual agreement evidenced by a single document in which two parties, called counterparties, agree to make period payments to each other.

The agreement spells out the instrument to be exchanged (which may or may not be the same), the applicable interest rate on each instrument (which may be fixed or floating), the timetable for making payments, and other provisions.
Swap contracts are tailor-made to meet the needs of the counterparties with the aid of swap specialists who serve as brokers and/or market makers. Swaps trade in the OTC market.
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The Eurocurrency Markets

Definitions: A Eurodollar is a U.S.-dollar denominated bank deposit held outside the U.S. More generally, a Eurocurrency deposit is a domestic-currency denominated bank deposit held outside the domestic geographical area.

Eurocurrencies are typically time deposits denominated in currencies other than those of the countries in which they are located.

Therefore, the eurodollar (eurocurrency) market is an international money market focused on short-tern credit flows while the eurobond market is an international capital
market focused on long-term bonds.
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 The

most important Eurocurrencies are the EuroCanadian dollar, Euro-Euro, Euro-Swiss franc, Euro-sterling, and Euro-yen.

Smaller

offshore banking centers which participate in the Eurocurrency market include such locations as the Cayman Islands, Bahamas, Bahrain, Luxembourg .
Singapore market is often called Asian dollar market.

The

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 The

Eurocurrency market therefore consists of those banks, called Eurobanks, that accept deposits and make loans in foreign currencies.

The

Eurocurrency market enables investors to hold short-term claims on commercial banks, which then act as intermediaries to transform these deposits into claims on final borrowers.

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The Evolution of the Market:

The development and expansion of the Eurocurrency markets have their roots in overt and covert events. 1) In the late 1950s British-owned banks utilized foreign currency deposits (in the UK) as a lending medium in order to save business that was at that time endangered by exchange controls (by the UK) on transactions in pounds sterling. In turn this lead to active solicitation of dollar deposits by banks in Western Europe.
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2) The Soviet Union: provided impetus for the early growth of the market. As the cold war heated up, the Soviet Union began to worry about the U.S. Government freezing its deposits in New York. The Soviets needed to maintain dollar accounts for international trade and investment. The dollar was then virtually the only currency acceptable worldwide. The Soviet Union responded to this problem by placing its dollar-denominated deposits in banks outside the U.S. jurisdiction. British and French banks were the primary recipients of these deposits. 71

3) Changes in U.S. Balance of Payment Situation: The 1945-50 period saw persistent surpluses. These were replaced by deficits in 1957. Deficits resulted in increased foreign holding of dollars. By mid 1958 European market in dollar deposits and loans had become established.

4) The Market as a Source of Short-term Funds: Supports trade financing activities of international banks. It facilitates foreign exchange transactions by banks and provides short-tern money market trading opportunities. International banks use the market as an outlet for placing surplus funds temporarily at attractive yields. Eurocurrency interbank market has become the central mechanism to channel flow of international funds among banks and this gave birth to the LIBOR as an important international interest rate 72

5) Regulatory Developments in the U.S.

(i)

"Regulation Q": Interest rate ceilings existed in the U.S. during the 1960s and 1970s. With higher interest on dollars deposited in the eurodollar market, funds moved to banks in Europe. Many U.S. banks opened European offices to receive these funds.

(ii) Federal Reserve "Regulation M": This regulation requires the keeping of reserves against deposits. Since reserves constitute idle funds, the cost of operating in the Eurocurrency market is relatively less since there are no reserve requirements in the eurocurrency market.
Many American banks moved some of their operations to the relatively unregulated eurocurrency market.
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(iii) The Controls and Restrictions on Borrowing Funds in the U.S. for Reinvestment Abroad: (voluntary in 1965, mandatory in 1968) forced many borrowers to seek sources of loans in Europe, thereby increasing the demand for funds deposited in the eurocurrency markets. (iv) The U.S. Interest Equalization Tax (1963): Imposed a tax on U.S. residents' earnings on foreign securities. This increased the interest foreign borrowers were forced to pay on funds borrowed directly from the U.S. market. By channeling funds through the eurocurrency market, this tax is avoided. 74

6) The Role of Narrow Spreads: The desire of depositors to receive highest possible yields and of borrowers to pay lowest possible costs are met in the eurocurrency market. Absence of regulation permits higher yields to depositors and lower costs to borrowers. 7) Desire of British Banks to maintain their position in international finance plus the favorable regulatory environment in the United Kingdom. 8) Confidence in Vehicle Currencies especially the dollar

9) The Role of OPEC: OPEC countries invest part of their petrodollars in the Eurocurrency Market so that the market provides a medium for the so called "Petrodollar Recycling. 75

10)

Other Features of the Market: Costs of complying with regulations are low since there are no deposit insurance assessments. Borrowers' credit worthiness is well known so that the need for credit investigation is low. No taxes are withheld from interest payments to eurocurrency depositors. Taxes and fees levied on euro banking operations are generally lower than those applied to domestic banking. Low costs per transaction because of relatively large size of transactions.
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Eurocurrency markets need not be located in Europe, though they originate in Europe. For example, in the U.S., domestic banks are (since 1981) permitted to open International Banking Facilities (IBF) which are computerized account records kept separate from U.S. banks' domestic accounts. They must be domiciled inside U.S. territory and focus on international commerce. They accept foreign currency denominated deposits. These "onshore/offshore" bank accounts are permitted in an effort to regain deposits lost to offshore banking operations.

IBF accounts are free from reserve requirements and assessment for deposit insurance. They are also exempt from federal taxes, becoming taxable only when transferred to regular accounts. 77

The primary participants in the Eurocurrency market are large banks called Eurobanks. Transactions are predominantly interbank, hence the market is frequently called the "interbank market." In addition, large scale or "wholesale" transactions take place between banks and non-bank customers. Transactions are typically priced off the London Interbank Offered Rate (LIBOR) which is a floating rate at which London banks lend to one another.

Interest rates on Euroloans to governments and their agencies, corporations, and non-prime banks are set at a fixed margin above LIBOR for the period and currency chosen.
78

 At

the end of each period the interest for the next period is calculated at the same fixed margin over the new LIBOR.

The

drawdown, the period over which the borrower may take down the loan, and the repayment period vary with borrowers needs. A commitment fee of about 0.5% per annum is charged on the unused balance. loans have multi-currency clauses giving borrowers the right, subject to availability, to switch from one currency to another on any rollover/reset date. This feature provides a potentially valuable exposure management for borrowers.
79

Eurodollar

Reference Rates of Interest: A reference rate of interest, for example U.S. dollar LIBOR, is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation.
LIBOR,

London interbank offered rate, is by far the most widely used and quoted. It is an interest rate charged by banks for S-T loans to one another. It is an important benchmark for mortgages, corporate financing, etc. It is officially defined by the British Bankers Association (BBA). BBA also calculates Yen LIBOR, Euro LIBOR, 80 and other currency LIBOR rates.

The

 Most

major financial centers also construct their own interbank offered rates for local loan agreement purposes.

These include:
FIBOR:

Frankfurt interbank offered rate

PIBOR:
SIBOR:

Paris interbank offered rate

Singapore interbank offered rate

MIBOR:
EIBOR:

Madrid interbank offered rate

Emirate interbank offered rate (interest rate charged

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by banks in the United Arab Emirates for interbank transactions)

Eurodeposit Creation:
Eurocurrency

deposits are subject to the same multiple expansion feature of a domestic banking system. are deposited in a Eurobank which lends them to deficit spending units and, in effect, creates new deposits.

Funds

82

Example: Stage A: Assume that IBM purchases computer components from a UK supplier, COMPUK, for $1m and pays with a check drawn on its Chase Manhattan Bank in New York. Assume also that COMPUK deposits the check in Westminster Bank, London. A Eurodollar deposit is now created since COMPUK has a dollar-denominated account outside the U.S. Typically, money center banks maintain accounts with one another. So, Westminster Bank deposits the check at Chase which now shows a change of ownership on the $1m deposit from IBM to Westminster.
83

Stage B: Now, suppose Volvo of Sweden obtains a loan of $900,000 from Westminster and uses the proceeds to pay for purchases from a another Swedish company, Stockhm 1. Stockhm 1 deposits the proceeds in the Bank of Sweden, thus creating another eurodollar deposit. When the Bank of Sweden initiates collection, $900,000 of Westminster deposit at Chase change ownership to the Bank of Sweden.

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Eurodollar Deposit Expansion: Main Features

Chase, NY Stage A Westminster, London
Deposits of COMUK +$1,000,000

Deposits of IBM Deposit at Chase -$1,000,000 +$1,000,000 Deposits of Westminster +$1,000,000

Chase, NY

Stage B Bank of Sweden

Deposits of Westminster Deposit at Chase Deposits of Stockhm1 -$900,000 +$900,000 +$900,000 Deposits of Bank of Sweden +$900,000
85

At this point, the level of Eurodollar deposit is $1,900,000 The process of expansion continues geometrically. The expansion is limited by the level of voluntary (discretionary) reserve held by each Eurobank. With a zero discretionary reserve, the expansion continues without limit unless the dollars are used to purchase products or services in the U.S. at which point the expansion process stops. The Asian dollar market grew to accommodate the needs of businesses that need U.S. dollars as a medium of exchange for international trade/investment. Favorable tax advantages in Singapore and Hong Kong, (e.g., low withholding taxes, reduced tax on offshore loans) encourage growth of the Asian market.

86

The Eurocredit Market:

Loans of 1 to 5 years (medium term) extended by Eurobanks are called Eurocredit Loans. These loans are popular with corporations/governments. Since Eurobanks accept short-term deposits, there exists the problem of maturity mismatch between deposits and loans. To avoid the risk Eurobanks commonly offer floating rate Eurocredit Loans. Loan rates float in accordance with movement of some market interest, such as the LIBOR - the rate commonly charged for loans among Eurobanks. Syndicated Eurocredit Loans are provided to large corporate or government borrowers by a group of banks participating in the syndicate. 87

The Eurobond Market

Eurocurrency and Eurocredit loans help to accommodate short and medium term borrowers respectively. The Eurobond was created to accommodate long-term borrowers. Partially the result of Interest Equalization Tax imposed in the U.S. in 1963 to discourage U.S. investors from investing in foreign securities. Foreign borrowers were thus forced to look elsewhere for funds and enter the Eurobond market.

The

Eurobond market facilitates the transfer of longterm funds from surplus spending units to deficit spending units around the world. Issued by MNCs, large domestic corps., governments, governmental enterprises, and internl institutions. 88

 The

market helps to link investors with borrowers around the world, and thus help to integrate the world's financial system.

The

Eurobond market, unlike the domestic bond market, is almost entirely free of official regulation. It is self-regulated by the Association of International Bond Dealers
.

The

bonds are sold outside the countries in whose currencies they are denominated and underwritten by an international syndicate of banks. simultaneously in a number of major capital
89

Offered

markets

 Eurobonds

feature different types of issues .. including straight fixed-rate, floating rate note, and equity related/convertible.

Foreign Bonds Underwritten by a syndicate and sold within the country of the denominated currency. Borrower/issuer is from another country These include Yankee, Samurai, and Bulldogs bonds.

90

Note Issuance Facilities and Euronotes:

Eurobanks

have responded to the competition from the Eurobond market by creating a new instrument called the Note Issuance Facility (NIF) which is a low-cost substitute for syndicated credits. allows borrowers to issue their own short-term Euronotes which are then distributed by financial institutions providing the NIF

It

NIF, sometimes called short-term note issuance facility, has some features of the U.S. commercial paper market and some features of the U.S commercial lines of credit. 91

1.

2.

3.

Internet Resources: www.imf.org/external/fin.html IMF website. Contains exchange rate quotes for selected currencies www.ny.frb.org/pihome/ststistics/forex12.shtml NY Fed site with noon forex rates. www.bis.org/publ/index.html BIS site contains annual reports, external debts, foreign exchange market activities etc.

92